Every year, I have a few S-corporation clients who complain that they have a tax liability on their personal return. Typically there’s also a comment made about how “other people” they’ve talked to have S-corps and “never pay anything in taxes.”
This conversation happens several times a year, and oftentimes it’s the same conversation with the same clients year after year.
S-corps can be a good vehicle for saving on payroll taxes (FICA/self-employment tax). But I encounter many business owners who believe that S-corps are a magical thing that takes away ALL taxes and solves all of their problems.
And it seems like the more I try to explain how “that’s not how it works,” the worse it gets. Even when I try breaking it down into “See Jane Run” terms.
It’s frustrating and feeds into my cynicism about this field and the whole “accountants should be proactive” discussion.
This is how I try to explain it.
“See Jane Run” Example of S-corps
Let’s say Jane is self-employed. She reports her income and expenses as part of her personal tax return.
Let’s say her business shows a profit of $50,000 after expenses. Jane takes out $30,000 for what she calls a “salary.”
For self-employed people, there is no such thing as a “salary,” so that $30,000 is not deductible and is meaningless for tax purposes. Jane will include $50,000 as part of her taxable income, and she’ll also be subject to self-employment/FICA taxes on $50,000 as well.
Now let’s say Jane is an S-corp. In this case, her $30,000 salary will have FICA taxes withheld on it at a rate of 15.3% (half will come out of Jane’s paycheck, half will be paid directly by the corporation). To figure the corporate deduction, take 1/2 of 15.3%, so 7.65% times $30,000 = $2,295 expense to the corporation. Jane’s S-corp will have net income of: $50,000 minus Jane’s $30,000 salary minus $2,295 of payroll taxes = $17,705 of corporate net income.
On her personal tax return, Jane will report her $30,000 salary as income. Payroll taxes have been withheld already on this, so she doesn’t have to pay self-employment tax on it. She’ll also report the $17,705 of corporate net income. This income is subject to income taxes but not self-employment tax.
So what is Jane’s savings? Look at the $17,705 of corporate net income. This income is not subject to self-employment/FICA taxes, so this is where the savings come in. The savings is calculated based on the self-employment tax calculation using 92.35% of self-employment earnings: 17,705 x 92.35% = $16,351 x .153 = 2,502. Jane saves around $2,500 by being an S-corp.
The key thing to remember about “Jane” above is that she still pays income tax on both her salary and the pass-through income from her corporation; the savings comes from self-employment/FICA taxes. If your S-corp is highly profitable, you still might have a stiff income tax liability.
Why Do “Other People” Pay So Little in Taxes?
ONE: This is where it gets almost impossible to answer. I don’t know why your neighbor has an S-corp and pays “no taxes.” I would have to look at your neighbor’s tax return to answer that question.
TWO: I realize that my “see Jane run” example can be tough on the mind. But that’s the thing about this stuff — people get mad that accountants don’t break things down for them better and don’t make things easy to understand. But look at my “see Jane run” example above and tell me how much more it could be simplified before losing all meaning. And that’s the problem — there reaches a point where you can’t simplify things any further because all context and meaning is lost.
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